To start trading in financial markets, it is necessary to study them, and for this, there are two basic types of analysis: technical analysis and fundamental analysis. In this article, we will focus on technical analysis, what it is, what its basic principles are and some of the most used technical indicators.
What is technical analysis?
Technical analysis is based on the analysis of graphs, with the help of indicators and oscillators that allow analysing the movements of the market and determining the possible direction that a price will take, in order to open a position that allows generating profits.
Technical analysis is primarily rooted in historical data, price patterns, and the trends they depict. It does not focus on the study of underlying causes driving prices, but rather on the consequences observable on the charts. Consequently, this type of analysis is most suitable for short timeframes. In fact, it is typically the type of analysis that traders use, as opposed to fundamental analysis which is typically used by investors.
Core principles of technical analysis
Technical analysis is based on three core principles, which are the basic premises to start understanding how this type of analysis is used to trade in financial markets. Let’s see what they are.
Price is key
Technical analysis is deeply rooted in the idea of price. While fundamental analysis is based on the concept that assets have an intrinsic value (i.e., different from their current price, hence there is an investing opportunity), technical analysis often looks at prices to determine the entry and exit point. It does not consider external data, such as economic, political, or social factors, or internal data (such as the company’s financial statements) to determine whether the asset represents a good opportunity.
In other words, technical analysts primarily analyse graphs and technical indicators to support their strategy. For example, if the graphs and multiple technical indicators show that the asset is in a bullish run (increasing price trend), then they open a position.
History repeats itself
Saying that “the market has memory” is another way of seeing this second principle of technical analysis. This basic premise establishes that the market moves in a similar way in response to a stimulus or similar situation so technical analysis is based on the study of past movements to try to predict those that follow and thus open and close successful positions.
In fact, many traders have made significant profits because they managed to identify patterns that repeat themselves and acted accordingly, knowing that history repeats itself. This point is closely linked to human nature and the fact that we act similarly in similar circumstances.
In technical analysis, one of the primary methods to analyse a chart is by observing the trend within a specific timeframe. The significance of trends is paramount, to the extent that there exists an entire set of trend indicators dedicated to illustrating trend patterns and potential shifts. The ability to identify trends is critical for traders employing technical analysis, as it significantly influences their decisions regarding market entry and exit points.
Depending on what type of trader you are and in what time frame you operate, there are generally three types of trends:
- Long-term trend typically spans several years. It is used by long-term investors or traders who hold positions for extended periods.
- Medium-term trend refers to the trend often analysed using monthly or weekly charts. It provides a broader view of the market to assist traders in making decisions within shorter timeframes.
- Short-term trend refers to shorter durations, such as daily or intraday charts. It is analysed for opening and closing positions within a single day or a few days.
Main theories of technical analysis
The theories of technical analysis encompass a collection of tools and techniques employed by analysts to examine asset prices and anticipate their future movements. Here are some of the main ones.
The Dow Theory is one of the most important theories of technical analysis. It was developed by Charles Dow, founder of the Wall Street Journal and one of the fathers of the modern stock market.
The Dow Theory is based on the idea that asset prices move in trends and that these trends can be categorised as:
- According to timeframe: primary (trends that last a year or more), secondary (medium-term trends that last from a few weeks to a few months ), tertiary (a few days to a few weeks, or short-term trends)
- According to direction: upward (bullish), downward (bearish) or lateral (sideways).
- According to the phase of the trend:
- Bullish trend phases: accumulation (price and volume increase), public participation (retail investors/traders notice the increase and start to join in) and excess phase (large, experienced traders start to exit positions while the general public still adds to their positions).
- Bearish trend phases: distribution (news of a downtrend starts to be distributed in the investing community), public participation (average investors start to exit their positions), and panic phase (investors have no hope of a trend reversal and keep selling their assets).
The characteristics of a trend can also be influenced by factors such as volume, the correlation of indices, or the significance of closing prices at the end of a trading session. These factors can provide additional insights into the strength and dynamics of the trend.
Find out more about Dow Theory.
The Fibonacci sequence is another important tool of technical analysis. It was developed by Leonardo Fibonacci, an Italian mathematician from the 13th century. His theory is based on a numerical sequence, where each number is the sum of the two previous numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc.
The Fibonacci sequence is found in many natural patterns and is used in technical analysis to identify support and resistance levels.
In fact, when it comes to technical analysis, it is widely used due to the importance of the following indicators:
- Fibonacci golden ratio
- Fibonacci time zones or time targets
- Fibonacci fan
- Fibonacci retracement
- Fibonacci extensions
Check this guide on the Fibonacci sequence for a detailed explanation of how to use this theory.
The Elliott Wave Theory was developed by Ralph Nelson Elliott in the 1930s. This theory is based on the idea that asset prices move in repetitive patterns, which can be divided into impulse waves (that show a pattern) and corrective waves (that oppose the trend):
- Impulse waves move in the direction of the main trend
- Corrective waves move against the trend
- Each set of waves within the same pattern is known as fractal investing
A complete Elliott wave sequence will cover movements 1,2,3,4,5 – a,b,c. Read more about Elliott Wave theory to find out how to identify the waves correctly.
Another pivotal aspect of technical analysis is the use of renowned charts. Generally, charts depict market movements over a specific time period. They visually represent a line connecting consecutive closing prices.
There are multiple types of charts:
- Line charts
- Bar charts
- Candlestick charts
- Point and figure charts
- Renko charts
Chart analysis or technical chart analysis is a technique that involves studying price charts of financial assets to identify patterns and trends that may provide insights into future market movements. Some examples include hammer candle and death cross.
Chart analysis is rooted in the concept of price action, which suggests that market behaviour repeats itself in identifiable patterns. Some of the significant chart patterns include:
- Reversal Patterns: Examples of trend reversal patterns are the head and shoulders, double tops, and double bottoms.
- Continuation Patterns: Examples include flags, triangles, and wedges. If the same price trend continues after these patterns, they are known as continuation patterns.
Technical indicators are mathematical calculations or statistical formulas applied to historical price and volume data. By analysing these indicators alongside price charts, traders gain additional information to aid in making predictions and decisions regarding the future direction of an asset’s price.
Technical indicators are classified into different categories:
- Trend following indicators (identify/confirm a trend), such as moving averages
- Volatility indicators (measure the degree of price fluctuations), such as Bollinger bands
- Oscillators (to identify overbought and oversold conditions), such as Relative Strength Index (RSI)
- Momentum indicators (assess the speed and strength of price movement), such as RSI and stochastic oscillator
- Support and Resistance Indicators (such as the Fibonacci sequence)
Alternative to technical analysis
While technical analysis provides valuable assistance in detecting historical cycles, trends, and market entry and exit points, understanding the financial health of a company requires a different approach.
This is where fundamental analysis comes into play, forming the foundation of the value investing philosophy. Fundamental analysis focuses on assessing a company’s financial statements and other relevant data to evaluate its intrinsic value.
Read more about technical analysis and trading:
- Support and resistance
- Best trading books
- Trading guide
- Best traders
- Money management strategies
- How much a trader earns
- Best trading platforms
Summary: technical analysis
In essence, technical analysis is a trading discipline that relies on interpreting past events to predict future price movements of financial assets. It solely relies on the information conveyed by price through various patterns, figures, and indicators.
What is the main difference between technical analysis and fundamental analysis?
Technical analysis focuses on studying price patterns, trends, and indicators to predict future price movements, while fundamental analysis assesses a company’s financial health, including its financial statements, earnings, and industry factors, to determine its intrinsic value.
Which timeframes are commonly used in technical analysis?
Technical analysis can be applied to various timeframes, depending on the trading style and goals of the individual. Common timeframes include daily, weekly, and monthly charts for longer-term analysis, as well as shorter intraday timeframes such as hourly or 15-minute charts for more active trading.
Are technical indicators always accurate in predicting market movements?
While technical indicators provide valuable insights, it’s important to note that they are not infallible and should be used in conjunction with other forms of analysis. Market conditions, unexpected events, and other factors can influence price movements, leading to potential deviations from indicator signals.